The first two months of 2013 has seen a surge in currency volatility, bringing with it a boost in activity in the worlds largest financial market. After a 2012 which many FX brokers want to forget, as low market volatility kept trading volumes low, 2013 has clearly begun with a bang, says Gerald Segal, managing director at FX analysis firm LeapRate. That increase in volatility, and resulting increase in activity, in the foreign exchange market has come as the dominance of the risk-on/risk-off (RORO) trade which has driven action in the financial markets in recent years has receded. Correlation among currencies rose to extreme levels, as FX investors slavishly followed the fortunes of the worlds equity markets. The RORO trade saw investors buying perceived risky currencies, such as the Australian dollar, when sentiment was positive, and retreating into havens, such as the US dollar, when optimism waned. However, with the main threats to the global economy and financial system a eurozone break-up, a recession in the US and a hard landing in China receding, investor optimism has picked up. That has prompted a breakdown in currency correlation and allowed currencies to trade to their own beat. A general risk-on trade has brought more cheeriness to investors and more action to the currency markets as well, says Segal. The result has been that correlation among currencies has dropped to its lowest level in nearly 10 years and allowed currencies, instead of following swings in global risk appetite, to react to country-specific factors. That has seen currency volatility, subdued in recent years, spike higher. The first evidence of this has come in the yen, which has dropped sharply as Japans new government under prime minister Shinzo Abe has declared its intention to engage in aggressive monetary easing in a bid to reflate its economy. Maurice Pomery, chief executive at FX research firm Strategic Alpha, says the rise in yen volatility has been the main driving force behind the plunge in the currency. That, he says, is because option traders, who had become accustomed to the yen trading in relatively tight ranges, were caught off guard by the sudden spike higher in volatility, which forced them into the cash market to sell the yen to preserve their positions. The reason for that is many option traders attempted to cheapen their bullish dollar/yen positions by selling knock-outs, which, as the name suggests, cancels their underlying positions if the currency pair trades up through a certain level. In a subdued volatility environment, the strategy works well, says Pomery, making it less expensive to hold a position. The trouble is, if the currency keeps moving, you get knocked out of your position, he says. So a lot of people who were bullish dollar/yen ended up getting knocked out. And then, of course, with volatility spiking higher, investors could not afford to buy options so they had to buy cash instead. Increased volatility, in other words, exacerbated the move in the spot market, creating a spiral that added to the momentum of the yens fall. The yen is not alone. Sterling volatility has also picked up sharply, as the easing of worries about the future of the eurozone has allowed investors to focus on the UKs economic problems and the apparent willingness of the Bank of England to see its currency weaken. As was the case in the yen, rising sterling volatility looks set to exacerbate the fall in the pound as investors are priced out of the option market and forced into cash. Indeed, all over the currency market, individual country-specific themes are developing as the RORO trade recedes and foreign exchange re-emerges as an uncorrelated asset class in its own right. Pomery says that with the massive injection of liquidity from the worlds central banks in the wake of the financial crisis, it made currency investors complacent, with currency volatility remaining too low for too long. For investors, the rise in volatility makes it harder for investors to put on medium-term currency positions as option prices become more expensive. That, in turn, will create more volatility in the cash market. The days of tight ranges and low volatility have gone and traders are going to have to adjust to that, says Pomery. There is a more positive side to the recent rise in currency volatility and break down in currency correlation: investors can look to differentiate their foreign exchange exposure and make more targeted investment decisions now the RORO trade is fading.